Thursday, November 29, 2012

A recent
opinion piece by Robert C. Pozen, a non-resident fellow in
Economic Studies at the Brookings Institute, entitled "The Underfunding of Corporate Pension Plans"
examines how the current low interest rate environment is impacting the ability
of corporations to guarantee their payouts to future pensioners. I
realize that I've posted on this several times recently, however, with the
current seemingly endless period of very low interest rates and the growing
number of pension-eligible Americans, this issue is going to get worse before
it gets better and may well have a big negative impact on both future
pensioners and the bottom line of many American corporations.

Pension plan
future obligations are calculated using a "discount rate", the return
that the plan can reliably expect to earn on its portfolio of investments
between now and when the plan begins to pay out benefits. Long-term
benefit obligations are calculated using the benefit schedule and a projection
of the life span of the workers who will collect these benefits. The
lower the discount rate (or rate of return) the higher the plan's estimated
obligations and vice versa. With the current low discount rate (or, in
other words, low return on the low-risk investments (i.e. bonds) that are held
by pension plans), there is a growing gap between what companies have set aside
for our pensions and what they will have to pay out in the future. This
is what is termed the underfunding pension problem. Corporations will
have choices to make; make up the shortfall which cuts into corporate profits,
raise pension contributions, invest in higher risk and hopefully higher return
investments or cut benefits to existing and future beneficiaries. Each
option has both an upside and an accompanying downside.

Recently,
the Senate passed Surface Transportation Bill S.1813 which
changed the rules for calculating the future obligations of private sector,
single-employer sector pension plans. These changes can be found in Section 40315 , "Pension Funding
Stabilization", hidden among legislation for child seats, odometer
tampering and impaired driving countermeasures. Sneaky, huh?
In the past, corporations used a discount rate based on the average
interest rate on two year highly rated, low risk bonds. This new
legislation allows corporate pension plans to now use a discount rate that is
an average of interest rates over the past twenty-five years. Keeping in
mind that higher interest rates were the norm during most of the past two and a
half decades, the discount rate for most pension plans will increase by one to
two percentage points from four to six percent. Remember, the
higher the discount rate, the lower the plan's estimated future obligations
which lessens the corporation's contributions. Pension plan liabilities
are estimated to change roughly 15 percent for every one percentage point
change in the discount rate; the higher the discount rate, the lower the
apparent, actuarial obligations. As if by magic, pension underfunding has
been cured!

Here are
examples of how this change has impacted three large corporations:

Just how big
is this underfunding problem in Corporate America? A study of 1,354 pension plans by David
Zion, Amit Varshney and Nichole Burnap of Credit Suisse suggests that the
private sector multi-employer pension plans (i.e union-related) alone are $369
billion underfunded with a funding rate of only 52 percent! Many of the
underfunded companies are found in the construction, transport, mining and
supermarket sectors. Funding rates below 65 percent are considered to be
critical.

On the
upside of the recent legislative changes, insurance premiums paid by
corporations to the Pension
Benefit Guaranty Corporation, a government entity that
guarantees up to $56,000 in annual benefits for bankrupt companies with
underfunded pension plans, will rise. PBGC is currently protecting
pensions for 44 million participants in more than 27,000 pension plans and in
thirty-seven years, has covered pensioners in 4,300 failed pension plans.
In 2011 alone, 152 underfunded single-employer pension plans terminated,
pushing PBGC's total obligations up to nearly $107 billion. In 2011, the
Pension Benefit Guaranty Corporation recorded a deficit of $26 billion and paid
out nearly $5.5 billion to pensioners; under the new legislation, premium
increases of $9.6 billion over the next decade would take place. While
it's a start, one would hardly expect that PBGC would have the means to bailout
a massive pension failure. Here's a quote from their 2011 Annual
Report:

"Nonetheless,
PBGC’s obligations are clearly greater than its resources. We cannot
ignore PBGC’s future financial condition any more than we would that of the
pension plans we insure."

Reassuring,
isn't it? It's especially reassuring when one realizes that American
taxpayers are on the hook for any PBGC funding shortfalls.

The new
pension legislation is phased out by 2016, however, if interest rates are still
very low at that time, we can expect lobbyists representing the pension plans
of Corporate America to come begging hat in hand for another kick at the higher
discount rate legislation can. Right now, Congress is just kicking the pension can further down the road since the pension obligations will exist no matter
what legislative changes are made. Remember, the pensions must be fed!

Tuesday, November 27, 2012

We are
hearing a lot about the looming fiscal cliff but there is one aspect of the
pending changes to the tax code that has received little or no coverage, the
impact of the expiring tax cuts on the federal estate taxes and state estate
tax revenues. A paper by Norton Francis of the Urban-Brookings Tax
Policy Center looks at the negative impact of the sunset of the 2010 Tax
Relief, Unemployment Insurance Reauthorization and Job Creation Act (the 2010
Act) on state tax revenue and suggest that the resurrection of revenue from
federal credits for state estate and inheritance taxes may help states replace
this lost income.

Let's open
by taking a look at the history of estate taxes in America. The modern
federal estate tax was launched in 1916 and, in 1924, was expanded to include
gifts (i.e. transfers of money between individuals). The 1924 law stated
that gifts that were given while the giver was alive would be taxed as part of
the estate but that taxes paid on these gifts would eventually reduce the total
tax owing on the estate. A state tax credit equal to 25 percent of the
federal tax was implemented to share the estate tax with states and, in 1954,
was changed from a percentage of the federal tax to the "credit for state
death taxes" or CSDT of up to 16 percent.

Before the
implementation of the Economic Growth and Tax Relief Reconciliation Act
(EGTRRA) in 2001, every state imposed an estate tax equal to the credit for
state death taxes of up to 16 percent which had the effect of transferring the
estate tax revenues from the federal level to the state level. This also
meant that all states had roughly the same taxation level for estates, handy if
you happened to inherit property located in more than one state.

How much
revenue did the estate tax raise prior to implementation of the EGTRRA changes?
In 2000, the federal government collected $24.4 billion from estate taxes
from an aggregate gross estate value of $130.4 billion. It seems like a
pittance when compared to a trillion dollar deficit but every penny counts.

All of this
changed in 2001. Much to the surprise of most analysts, President Bush's
2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) actually ended
up with a complete phase-out of estate taxes in 2010. It also phased out
the state level CSDT by 25 percent a year in each of 2003, 2003 and 2004 and
replaced it with a tax deduction in 2005. How did these changes impact
Washington's estate tax revenue? Between 2001 and 2009, the federal
estate tax revenue ranged from $21 billion and $25 billion despite a five-fold
increase in the exemption, a two-thirds drop in taxable estates and a 10
percentage point drop in the top tax rate. This relatively stable federal
government estate tax income stream was maintained for two reasons:

1.) The
average value of estates rose.

2.)
Replacing the CSDT with a tax credit shifted between $4 billion and $5 billion
in tax revenue per year from the state level to the federal level.

By 2010,
fewer than 7,000 estates paid $13 billion in taxes and fewer than 1,500 estates
paid $3 billion in taxes in 2011.

In 2001 when
EGTRRA replaced the CSDT with a less valuable deduction, states acted in
different ways. Some did nothing since their state estate taxes were
coupled to the CSDT and ended up collecting no taxes. Others repealed
their own estate taxes, also resulting in no estate tax revenue. Some
states adopted their own estate taxes further complicating the issue for
estates with holdings in multiple jurisdictions. Here is a chart showing
which actions each state took in response to the end of the CSDT money-maker:

Here is what
happened to estate tax revenues in New Mexico which did not amend its tax laws
when the federal government ended CSDT (a dormant state) (please note that
federal tax revenues are in green and state revenues are in blue):

Revenues
dropped from $28 million in 2003 (one percent of total revenues) to zero by
2010.

Here is what
happened to estate tax revenues in Maryland which has its own inheritance
taxes:

Maryland's
estate tax revenues barely budged since they decoupled their estate tax system
from the federal system.

The tax
provisions of EGTRRA were extended by the 2010 Act until the end of 2012 and
will expire on January 1, 2013. The 2010 Act actually reinstated the
estate taxes for 2011 and 2012 with a higher exclusion amount and lower tax
rate and, what's worse for Americans is that, on January 1, 2013, the top
federal tax rate on estates will rise from 35 percent to 55 percent and the
estate property exclusion will drop from $5.12 million to $1 million.
This higher rate will be a bit of a windfall for Washington, bringing in
an estimated $31 billion in 2013. Restoration of the CSDT in 2013 would
reduce federal government estate tax revenues by $5 billion and would increase
the revenues in dormant states (those that had estate taxes that referenced the
CSDT prior to its expiry but which now have no estate taxes) by $3 billion
(i.e. see New Mexico above), half of which would end up going to California and
Florida.

It is
interesting to see how changes to federal legislation regarding mundane issues
such as estate taxes can have such a big impact on the level of revenues at the
state level and how these changes can lead to confusion for both taxpayers and
legislators. Until the President and Congress come to a saw-off regarding
the expiring 2010 Act, states and taxpayers will find it very difficult to plan
for their futures. As an aside, I also find it hard to imagine that
governments around the world will not be tempted to take a greater share of the
estate pie in this age of rapidly growing debt levels. It's a target that
is just too easy to hit, particularly over the next 20 years as baby boomers depart this orb in growing numbers.

Monday, November 26, 2012

A brief opinion piece on the Brookings Institute website by William A. Galston gives us
an interesting solution to the coming fiscal cliff political brinksmanship.
The Republicans are firmly entrenched in their "no tax
increases" philosophy and the Democrats don't want to increase taxes on
families making less than $250,000 per year. Since the two sides of the
spectrum obviously cannot agree on long-term changes to the tax code between
now and December 31, 2012, a bit of tweaking here and there may just solve the
problem at least temporarily. Without such an agreement, one thing is certain, the world's
markets will react adversely. As it stands now, taxes will go up on January
3, 2013, impacting the "middle class", resulting in slower economic
growth according to Congressional Budget Office projections and a loss of confidence in Congressional ability to problem solve.

Let's look
at the summary of tax receipts as a percentage of GDP from 1930 to 2017 from the Office of Management and Budget:

Since the
Second World War, total tax receipts have almost never been higher than 20
percent of GDP and have averaged 16.0 percent
since 1930.

Here is a
summary of total outlays as a percentage of GDP over the same time period:

Since 1976,
it is rare that outlays have been less than 20 percent of GDP, ranging from
18.2 percent in 2001 and 2001 to 25.2 percent in 2008. And thus, the
problem. The author notes that the U.S. government will need
revenues of between 20 and 21 percent of GDP to stabilize the national debt
(note the word "stabilize" rather than the word "reduce").

Since past
history shows that reforming the tax code is a very long and painful process
even under the best of circumstances where both sides aren't acting like elementary school children, an interim solution is required that will
prevent both sides from pouting. Here are Dr. Galston's suggestions:

1.) Both
sides accept a cap of $50,000 on itemized deductions (i.e. health care, mortgage
interest, charitable deductions, state and local taxes, tax preparation fees
etcetera). This would have the greatest impact on individuals making more
than $200,000 annually.

2.)
Republicans would agree to raise the tax rates on dividends and capital gains,
closing the gap between the very low rates of today and those that were in
place before the Reagan-era tax reform. Here is a graph showing what has happened to
dividend and capital gains tax rates since 1961:

Common sense would tell us that it looks like there should be plenty of room to move rates up, unfortunately, there is a shortage of that particular commodity in Washington.

3.) In
return for these compromises, the President and his fellow Democrats would agree to leave the rates on
earned income at current levels.

This
scenario gives both sides of the spectrum some form of a victory that they can
brag about to their backers, however, in this winner-take-all,
loser-gets-nothing world, it is unlikely that even modest compromises like these
will be palatable to both sides. That said, perhaps this solution is just too simple for the complex minds of Congress to absorb.

Wednesday, November 21, 2012

A brief article on the Knowledge at Wharton
website examines the spectre of a default on United States Treasuries. It
gives us an interesting look at background information about America's mounting
debt and what could happen to the "riskless" Treasury market in the worst case scenario.

Here is a
quote from Founding Father Alexander Hamilton:

"A national debt if it is not excessive will be to us a national
blessing; it will be a powerful cement of our union. It will also create a
necessity for keeping up taxation to a degree which without being oppressive,
will be a spur to industry.”

Let's open
with a look at the latest debt numbers. The debt can be broken down into
two parts, the marketable debt which includes Treasuries and the non-marketable
debt which includes intra-governmental loans, basically, money that is borrowed
from one part of government to fund another part. Here is the breakdown:

Notice that
nearly 67 percent or $10.887 trillion of the total debt is marketable and just
less than half that amount (33.05 percent) or $5.374 trillion is
non-marketable. With total debt of over $16.2 trillion dollars, the debt
ceiling of $16.4 trillion is likely to be breached by the end of 2012 or early
2013 at the latest.

Fortunately,
the average interest rate on America's marketable debt sits at a very low 2.075 percent, down from 2.306 percent in
October 2011. Interest on the non-marketable portion of the debt is slightly
higher at 3.588 percent, down from 3.932 percent a year earlier. This
averages out to 2.560 percent when all debt is included. Here
is a bar graph that shows how interest rates on the outstanding debt have
changed over the past 24 months and how much cumulative monthly interest has been paid on
the debt:

Finally, to
put all of this into perspective, the latest GDP figures from the Bureau of
Economic Analysis show that the U.S. GDP reached $15.7757 trillion in the third quarter of
2012. This means that the current marketable debt-to-GDP ratio is 69
percent and the current non-marketable debt-to-GDP ratio is 34.1 percent for a
total debt-to-GDP ratio of 103.1 percent. This is up very substantially
from the 60 percent level reached during the balanced budget years of the
Clinton Administration. According to University of Connecticut School of
Law Professor James
Kwak, the debt-to-GDP could well rise to 200 percent by 2035, a level
that is higher than that of all European debtor nations.

Now that we
have the latest data in mind, let's go back to the "spectre of
default", a subject that is particularly pertinent now that the fiscal
cliff is staring us in the face.

As most of
us know, if our spending exceeds our earnings for very long, eventually, we
will find it difficult to get additional credit and lenders will force us to
pay higher and higher interest rates because they will be increasingly worried
about default. Unfortunately, such does not appear to be the case for the
United States; month after month, we watch Washington's debt rise as interest rates fall to multi-generational lows. As the world's reserve currency, investors regard
Treasuries as "riskless" because the government stands behind them
with the power of taxation. For a very short time, it appeared that the
euro might provide some competition for the power of the almighty U.S. dollar
as the world's choice of reserve, however, as we have seen over the past two
years, Europe's sovereign debt crisis has removed the euro from the
competition. The only currency that could ultimately replace (or
accompany) the U.S. dollar, China's yuan, is not quite there yet, however, as
shown on this graph, the Asian impact on the world's economy will continue to
rise at the expense of the current developed economies, particularly that of the United States:

Just to show
you how powerful the U.S. dollar is as the world's reserve currency, at the end
of September 2012, foreign nations owned $5.455 trillion worth of Treasury securities
or 50.1 percent of the total marketable debt.

Unfortunately,
there is no political will to actually reduce the debt. Every suggested
remedy is unpalatable to one side of the political spectrum or the other.
While the investment community generally regards Treasuries as
"riskless" because of the government's power of unlimited taxation,
in reality, such is not the case. At some point, no matter what the current perception is, it may be necessary for
the government to default when the debt reaches an unserviceable level.
Since 1800, 68 governments have defaulted on their sovereign debt with
Russia (1998) and Argentina (2002) being the most recent cases.
Admittedly, neither of these nations had currencies that were the world's
reserve, however, both defaults sent shudders through the world's economy.

What would
happen if the United States did elect to default? First, the government may choose
not to default on all of its debt; it could choose to delay interest payments
and/or extend maturity dates on some or all bonds. The losses on Treasuries
would impact Treasury investors, other levels of government, corporations,
pension plans, insurance companies and would likely result in dropping stock
market and real estate valuations. Interest rates on Treasuries would
rise as the risk premium rose and this would push up interest rates for
consumers, corporations and municipal and state governments. Credit
default swaps on Treasuries, a form of insurance that pays off when a bond
defaults, would have to be paid out, likely bankrupting the firms that sold
them along with the owners of the swaps.

Since it
appears obvious that the debt burden cannot rise forever, Washington has
choices to make:

1.) Cut
spending.

2.) Raise
taxes.

3.) Allow
inflation to rise which would both increase tax revenues and shrink the
"real value" of older debt. This would have the downside of
impacting the value of savings.

4.) Allow
the economy to grow at a faster rate than the debt. This would produce
bigger tax revenues that could potentially pay down the debt if spending growth
was restrained.

Each of
these ideas has politically driven weaknesses; no one wants to cut their pet
program (i.e. social safety net including Medicare and Social Security and
defense and raising taxes is politically unpalatable to conservative Americans.
Promoting economic growth has not worked in the past; over the past
decade, debt growth has outstripped economic growth, leaving America with a
debt-to-GDP level that is up two-thirds from its level at the turn of the
century.

The authors
suggest that raising taxes, while unpalatable, is probably the most reasonable
scenario. Total federal, state and local tax revenue in the U.S. was 24.8
percent of GDP in 2010, the lowest among all G-7 nations. By comparison,
taxation as a percentage of GDP was 31 percent in Canada, 42.9 percent in
France, 36.3 percent in Germany, 43 percent in Italy, 26.9 percent in Japan and
35 percent in the United Kingdom. As well, 150 nations around the world
have a form of national value-added tax. The overall tax rate on goods
and services in the United States was 4.5 percent in 2010 compared to more than
10 percent in much of Europe. While increases in income tax revenue generally reduces economic output, such is not the case for value
added taxes.

One way or
another, Washington has a long way to go before we can be assured that we are going to avoid the spectre of default. Perhaps the
national debt has not proven to be the blessing that Alexander Hamilton
foresaw.

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About Me

I have been an avid follower of the world's political and economic scene since the great gold rush of 1979 - 1980 when it seemed that the world's economic system was on the verge of collapse. I am most concerned about the mounting level of government debt and the lack of political will to solve the problem. Actions need to be taken sooner rather than later when demographic issues will make solutions far more difficult. As a geoscientist, I am also concerned about the world's energy future; as we reach peak cheap oil, we need to find viable long-term solutions to what will ultimately become a supply-demand imbalance.